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Analysis Firing off the current industry standard profit warning yesterday Microsoft CFO John Connors blamed the usual suspects. To an extent this is justifiable, because Microsoft remains dependent on PC sales, and if PC sales are sluggish then Microsoft software revenues ought to slow to match. But there are a few factors special to Microsoft that could mean it's worse than that, and that maybe the Redmond money machine is finally starting to come apart.

Microsoft's business at the moment consists of three basic product areas: desktop operating systems, desktop applications, and server software. Microsoft's ambitions lie in the area of services and applications. The profit warning however essentially covered all of these, so on the one hand we've got poor PC sales and a slowdown in corporate IT spend hitting traditional revenue areas, while on the other "consumer online services and advertising," the precursor of the services model Microsoft hopes will be its future when the PC business goes away, is currently failing to cut it as a replacement.

All of these woes might go away just as soon there's an upturn and the PC companies can start happily counting their winnings again, but it's by no means automatic. PC prices have fallen dramatically over the years, and the fire-sale factor isn't going to change that in the short run. But Microsoft has historically set its face against cutting the cost of Windows licences to OEMs, which means - as OEM chief Joachim Kempin's subpoenaed documentation confirmed during the trial - that Microsoft's share of the revenue generated by a PC climbed as the prices fell.

Pressures on Windows pricing

This obviously doesn't work in the long run, if prices keep falling, but it's worked so far - the profit warning may be the first sign of it stopping working. Note too that if Microsoft keeps its prices up and PC sales continue to climb while prices continue to fall, there will be times when Microsoft continues to do well while the PC companies take a hammering. Microsoft has therefore tended to be cushioned against the woes of the hardware companies, both by price maintenance and by the rigours of its OEM contracts.

Again though, it's worse than that. Aside from the determination to keep Windows prices up, Microsoft has in numerous areas been striving to increase its per-PC revenue. No less a person than Steve Ballmer has been heard musing hopefully on the subject of getting people to think of Office as part of the standard set of software that should ship with a PC (which means another nice slug of licensing revenue if that's achieved). Then there's the fact that the Win2k price was set at NT rather than Win9x levels, while the positioning and packaging of WinME plus the progressive extermination of Win98 from the sales channels will tend to wipe out Win9x in the business market, and force businesses to pay the Win2k level for their client machines. And alongside this we have the steady squeak of licence Ts & Cs being tightened, and the increasingly strident activities of the Microsoft anti-piracy squads.

So the big picture: as hardware prices go through the floor, Microsoft has been continuing and accelerating its programme to squeeze vastly more revenue out of every single PC that is sold. But it hasn't altogether been working, and it may now be hitting the wall entirely.

Getting Office everywhere is an obvious loser. It can't cut the price to match SmartSuite or StarOffice, because it's dependent on the high revenues it's achieved by making Office the standard in the business market. But having achieved this, it's faced with sceptical businesses implementing an 'Office 2000, just say no' policy. If the stuff you've got already works, and the stuff you're being offered by Redmond every year is expensive, why switch? The rental approach Microsoft plans to experiment with may turn out to be a fix for this, but currently it looks a bit of a punt.

IT management has been caught out in the past by Microsoft 'easy terms' deals that offer lower prices upfront in exchange for subsequent years of expensive 'per seat' thralldom, and surely some of them have started to notice by now. Consumers might go for a rental deal on Office if the software looks attractive enough, and they also might go for the services Microsoft wants to sell them if these look attractive enough. But you wouldn't put money on it yourself, would you?

The appliance threat

Meanwhile back at the core OS revenue front it doesn't look particularly promising either. There's clearly a point beyond which Microsoft can't squeeze the OEMs, and while it's a substantial leap of faith from that to say they'll start retaliating by shipping PCs with alternative operating systems, the pressure could induce them to concentrate more heavily on platforms that aren't exactly PCs. Linux appliances could become more attractive to them than the lowest price PCs, and they just might start to get more interested in Palm and Symbian as well, given that stuff you shove in your pocket and stuff that works with wireless is hot.

The difficulty with devices in these categories here is that they'll be cheaper still, and even a Microsoft defensive strategy that used CE as the sacrificial victim to avoid cutting Windows prices wouldn't add up to the right numbers. A decline in the PC platform could be triggered or accelerated by the hardware manufacturers increasingly viewing PCs as high spec, higher cost devices they could actually make a profit on, and cutting the low-cost non-PC platforms in at the bottom end, thus at last knocking back Microsoft's percentage take from the hardware business.

That wouldn't be the case, even if Microsoft was charging Symbian's $5-$10 rate in the device/mobile phone market, so long as Microsoft took a big slice of the market. But you've no doubt noticed that the three biggest handset companies are (largely) in the opposing camp, and that Microsoft partner Sagem (rather small, rather French) recently issued its own profits warning. Still, there's always Samsung...

No services, no future?
The woes from the online side of the Microsoft portfolio are also quite possibly bigger than just an industry downturn. Remember that in Q4 of this year Microsoft has been mounting a determined push for MSN, backed by subsidised hardware and sweethearts deals with retailers. Is the Great Uncomputed resolutely declining to get computed? We await confirmation of this through an AOL profits warning.

The trouble for Microsoft here is that MSN these days is supposed to be transforming itself into a huge all-encompassing portfolio of compelling services that consumers of all shapes and sizes (including the Great Uncomputed) will stampede towards, happily paying the rentals, tithes and tolls. This is something of a punt as well, but it's kind of key to .NET - if you build the service-based company and they don't come, then Microsoft's next generation won't be able to take over from the flagging sales of the last generation after all.

Of course it remains possible that what we have here is just a blip, that the software side will pick up with the PC business, and that online and services business has just faltered slightly on its road to victory. So we could say don't hold your breath, but think about it - if it really is starting to fall apart, with nobody around to cut off your air supply, maybe you could use the practice.